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Will Earnings Growth Bottom in Q2?

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The June jobs report has put the spotlight back on the Fed and what it will do to the QE program in the coming months. But hopefully the Q2 earnings season will provide enough of a distraction to not let the Fed become a full-time fixation for the market.

Given how low expectations have come down over the last few months, the Q2 reporting season may not carry many surprises. In fact, it may be reasonable to expect this earnings season to be no different from what we have become accustomed to seeing over the last few quarters. But two aspects of this coming earnings season need paying special attention to – revenues and guidance.

Management teams are typically very good at under-promising and over-delivering. That’s why roughly two-thirds of the companies end up beating earnings expectations. But an unusually big proportion of the companies came short of revenue expectations in the previous quarter. The situation has not been much different from the 23 S&P 500 companies that have reported results already, which includes companies like Oracle (ORCL - Analyst Report), FedEx (FDX - Analyst Report), Walgreen (WAG) and others. As such, more than earnings surprises, it will be interesting to keep an eye on revenue surprises.

But even more significant than growth rates and surprises will be guidance. Guidance is always important, but it has assumed even more significance this time around given the elevated expectations for the second half of the year, as the chart below shows.

Source: Zacks Data

We may not see much earnings growth in the first half of 2013, but consensus expectations are for a material growth ramp up in the back half of the year – from +2.7% in the first half to +9.2% in the second half.
Importantly, the growth expectations for the second half of the year are not due to easy comparisons – the level of total earnings expected in 2013 Q3 and Q4 represent new all-time high quarterly records, as shown by the chart below of total bottom-up consensus earnings estimates.

Source: Zacks Data

My sense is that estimates need to come down in a big way. The market hasn’t cared much in the recent past about negative revisions as aggregate earnings estimates have been coming down for over a year now. But if we are entering a post-QE world, as I believe we are, then it will likely be difficult to overlook negative earnings estimate revisions going forward. How the market responds to negative guidance over and the resulting negative revisions will tell us a lot about what to expect going forward.

Key Points

Total earnings for the 23 S&P 500 companies that have reported results already are up +8.1%, with 60.9% of this small sample beating earnings expectations. Revenues for these companies are up +5.3%, with a revenue ‘beat ratio’ of 43.5%.

Overall expectations remain low, with total earnings for the S&P companies as a whole expected to be up +0.4% from the same period last year, reflecting -0.8% lower revenues and modestly higher margins. This follows +2.6% earnings growth in Q1 on -1.3% lower revenues.

Estimates for Q2 have come down materially since the quarter got underway, with the current +0.4% growth down from +3.9% in early April.

Finance is the only major sector with a strong growth profile, with total earnings for the sector expected to be up +18.6% in Q2. This follows +7.6% earnings growth in Q1 and many quarters of double-digit gains for the sector. Excluding Finance, total earnings would be down -3.2% in Q2.

Finance reclaims its leadership role in the S&P 500, contributing more earnings to the index’s total than Technology this year for the first time since the 2008 crisis. The sector is expected to account for 19.2% of total S&P 500 earnings in 2013 compared to Technology’s 18%.

Technology earnings were weak in Q1 and they are even weaker this time around, with total earnings for the sector expected to decline -8.3% in Q2 after declining -4.2% in Q1. Weakness in hardware and semi-conductor industries more than offset the modest growth in software earnings. Excluding Technology, total earnings for the S&P 500 would be up +2.4% in Q2.

Estimate revisions remain in neutral territory at present, though Finance continues to experience strong positive revisions, while revisions for Basic Materials, Industrials, Staples, and Business Services predominantly to the downside.

Estimates for the second half of the year still reflect strong growth, with total earnings in the second half expected to increase by +9.2% after the +2.7% increase in the first half. Total earnings are expected to be up 6.4% in 2013 and +11.5% in 2014.

While there is not much growth, the overall level of total earnings is quite high. Total earnings were an all-time record at $252.6 billion in Q1 and are expected to total $250.3 billion in Q2. For the full year, earnings are expected total $1.03 trillion in 2013 and $1.15 trillion in 2014.

Net margins are expected to be up 20 basis points in Q2 as a whole and stay flat outside of the Finance sector. But expectations are for net margins to start expanding materially from the third quarter onwards. For the full year 2013, net margins are expected to top the 2006 peak and expand even further in 2014.

The bottom-up ‘EPS’ for the S&P 500 for 2013 and 2014 currently stands at $109.18 and $121.72, respectively. The top-down ‘EPS’ estimates for 2013 and 2014 currently stand at $107.83 and $114.80. (Note: All the data in this report is based on bottom-up estimates).

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